If 2020 has ignited a passion for social responsibility and climate change, ESG investing may be right for you.
Few would argue that 2020 has been a year of stress, worry, and uncertainty. It’s also been a year, however, that has brought to light the issues of social justice, social responsibility, and climate change. As consumers, we’ve grown more aware of when we travel, where we buy from, and who receives our vote. As investors, our awareness has gradually been increasing as well.
More and more investors are opting to align their portfolio with their social beliefs and ideals. In fact, as of July 30, ESG-themed ETFs had pulled in a record-setting $38 billion in new money for the year and topped $100 billion in total assets for the first time.1
What Is ESG Investing?
ESG stands for environmental, social, and governance investing. ESG falls under the broader umbrella of sustainable investing, utilizing a strategy that seeks to identify companies with business models that are likely to face headwinds or tailwinds driven by rapidly evolving regulatory, environmental, demographic, or technological trends.
While this approach can mean different things to different people, common objectives are converging around ESG. These include investors looking to make a positive impact, seeking to align their investment strategy with their values, and those looking to integrate ESG factors to achieve long-term sustainable financial performance.
While the objectives may differ from one investor to another, the strategy by which the goal is accomplished focuses on all three pillars of ESG:
Environmental Sustainability – Focuses on the responsible interaction with the environment to prevent the depletion or degradation of natural resources, allowing for long-term environmental quality. Examples that ESG investors focus on include:
- Fossil Fuel Reduction
- Pollution Reduction
- Ecological Protection
- Water Management
- Agriculture Sustainability
Social Sustainability – Categorized as the development of processes and structures to meet the needs of its current members while also supporting future generations' ability to maintain a healthy community. Examples that ESG investors focus on include:
- Community Support
- Diversity
- Human Rights
- Consumer Protection
- Animal Welfare
Governance Sustainability – This includes the use of accurate and transparent accounting methods, avoidance of conflict of interest in board selection, and ethical practices to support a company's stakeholders. Examples that ESG investors focus on include:
- Management Structure
- Employee Diversification
- Employee Relations
- Executive Compensation
While making money to meet future goals is the most crucial aspect of wealth planning, many people want to invest in issues that matter to them, hoping that they can make the world a little better for those who live in it. Thankfully, the industry has given us a chance to accomplish both goals with ESG factored investments.
Follow these five tips as you develop your strategy in utilizing ESG investments:
- Understand “sustainable funds” - I recommend starting your search at the U.S. Forum for Sustainable Investing, a site that provides the financial performance, screening, and advocacy of several sustainable funds. This isn’t a comprehensive list, however, and thus it’s essential to contact your financial advisor to determine the best solution for your needs.
- Focus on diversification - Allocating your investments towards companies that share a social vision can often lead to concentration risk, the risk of putting all your eggs in one basket. Focus on diversifying among higher, medium, and lower risk investments for both stocks and bonds.
- Consider factors beyond sustainability - While it’s important to have a positive impact on society, it’s equally important that your strategy aligns with your existing financial plan. Examples of other criteria to look for in your investments include the funds' management, turnover, expense ratio, and ESG criteria (among others).
- Continually monitor your investments - Ensure that each investment, as well as the combined allocation, remains in line with your preference and financial plan. Every three to six months is the perfect period between check-ups.
- Always make adjustments with the end in mind - Aligning your investments with your values is important, but this doesn’t mean you should miss your family’s financial goals to do so.
You can read an expanded version of these five tips in our article Socially Responsible Investing 101.
ESG vs. SRI vs. Impact Investing
In the realm of sustainable investing, you may have heard of other terms like Socially Responsible Investing (SRI) and Impact Investing.
What Is SRI?
Just as an investor seeks out companies that make a positive social or environmental impact, the SRI selection process could also include identifying and excluding companies that may not align with your philosophy. Such examples of exclusion may consist of companies that produce fossil fuels, manufacture guns, manufacture and distribute tobacco, and organizations that profit from gambling.
It’s important to note that the SRI asset selection process will be personal to you and your priorities. While you may be focused on climate change and avoiding gun manufacturers, others may be comfortable with these issues and instead focus on avoiding companies that manufacture alcohol and nuclear energy. Aside from the “typical” investment metrics like past performance and cost, SRI requires additional screening done by you or your investment advisor.
You may face challenges when working with an advisor that commits to a fiduciary oath. A fiduciary, as it applies to your advisor’s responsibility, is defined as a legal/ethical oath to manage client assets with the clients’ best financial interests in mind.2
As socially responsible investing is often based on personal values rather than financial prerogatives, you may find a conflict between your personal values and personal financial objectives.
Choosing to exclude alcohol and guns, for example, means that you also won’t profit from these industries. If you’re comfortable with the opportunity cost of not participating in these companies, SRI investing may be just right for you and your portfolio.
What Is Impact Investing?
Where SRI is based on exclusionary investment strategies, Impact Investing is based on the inclusionary process. This may include identifying companies that generate specific beneficial social or environmental effects in addition to financial gains.3
Examples of Impact Investing include:
- Financing of education
- Renewable energy
- Healthcare
- Affordable housing
- Micro-finance
While SRI and Impact Investing differs on many levels, there is a commonality in the potential challenges of aligning your personal objectives with your financial goals. One area that is specific to Impact Investing in the timeline associated with anticipated returns.
According to Forbes.com, “It is generally accepted that impact investments require far longer timelines for returns than other types of investment. The rationale behind this is that impact-orientated businesses take a long time to become financially self-sustainable.”4 This is not to say that Impact Investing is wrong, but it does highlight the importance of aligning your expectations, risk tolerance, and timeline with the overall strategy.
In Conclusion
Growing your wealth to meet future goals is the most crucial aspect of financial planning. As part of this journey towards financial independence, many people want to invest in issues that matter to them, hoping that they can make the world a little better for those who live in it.
While there are several ways to accomplish this, such as using socially responsible investing or impact investing, there are also challenges that accompany these strategies. Opportunity cost, inadequate due diligence, and a lack of congruence between profits and personal values are at the top of this list.
ESG investing, on the other hand, allows investors to align their money with their values while simultaneously seeking financial gains through prudent investing. To learn more about this, schedule a meeting with your financial advisor to discuss how ESG factors can apply to your current strategy.
If you don’t have a financial advisor or are working with someone that doesn’t support this approach, contact Lucid Wealth Planning to learn more about how we help clients with similar interests as you.
Contact Jeff Stewart directly if you’d like to discuss this information in more detail or determine its application to your situation specifically. Lucid Wealth Planning offers consultation via student loan analysis, budgeting, as well as comprehensive financial planning and investment strategies.
1 https://www.ft.com/content/20f6c929-2fbf-47d5-973c-8c18607fc604
2 https://smartasset.com/financial-advisor/what-is-fiduciary-financial-advisor
3 https://www.investopedia.com/terms/i/impact-investing.asp
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